In June, the IRS announced plans to launch a new National Research Program (NRP) which will conduct a compliance study for individual taxpayers. The program will provide updated and more accurate audit selection tools and aid the government in reducing the nation's tax gap. This promises to be the first of many in coming years.

In October 2007, the IRS will examine about 13,000 randomly selected individual tax returns from the 2006 tax year. We can expect similar samples to be selected in future years.

As time progresses, patterns of non-compliance change. Subsequently, the IRS must continuously update its data analysis system. For its automated detection systems to be effective, the IRS must have accurate and up to date data which will help them establish relevant and  precise parameters for acceptable income and expense items on tax returns. The IRS hopes that this program is the first step in achieving that.

What many taxpayers fail to recognize is that under an IRS examination, you can be requested to substantiate either a single line item on a tax return or every line item on the tax return. The IRS has the right to request all personal financial records for the years in question, even those that have no tax relevance (personal credit card statements, auto loans, etc.).

Many taxpayers cringe when they hear "IRS Audit". We strongly believe that proper planning can substantially lessen the monetary and emotional burden of an IRS examination. It all boils down to the three "Rs": recordkeeping, recordkeeping, and recordkeeping.

In the growing digital age, many purchases are made electronically and our initial thought is to discard our receipts or invoices. After all, we can simply bring up our online account information and show that the purchase price was deducted from our bank account or purchased with our credit card. This might be helpful in reducing paper clutter, but it alone WILL NOT substantiate a deduction on your tax return. A cancelled check or an online list of transactions from your bank account simply show proof of payment. Proof of payment alone will not substantiate an expense item claimed on your return. Invoices, receipts, and other statements must also be available to support your claim to what the expense or income item was.

Here are some basic record keeping guidelines from IRS Publication 552 Record Keeping for Individuals:

Basic Records
Table 1. Proof of Income and Expense

FOR items concerning your...	KEEP as basic records...
Income	• Form(s) W-2 • Form(s) 1099 • Bank statements • Brokerage statements • Form(s) K-1
Expenses	• Sales slips • Invoices • Receipts • Canceled checks or other proof of payment
Home	• Closing statements • Purchase and sales invoices • Proof of payment • Insurance records
Investments	• Brokerage statements • Mutual fund statements • Form(s) 1099 • Form(s) 2439

The following are acceptable forms of proof of payment:

Table 2. Proof of Payment

IF payment is by...	THEN the statement must show the...
Cash	• Amount • Payee's name • Transaction date
Check	• Check number • Amount • Payee's name • Date the check amount was posted to the account by the financial institution
Debit or credit card	• Amount charged • Payee's name • Transaction date
Electronic funds transfer	• Amount transferred • Payee's name • Date the transfer was posted to the account by the financial institution
Payroll deduction	• Amount • Payee code • Transaction date

   
The answer to the question of "How long should I keep these records" can vary greatly. The seven year rule is still a good approach; however, some documents can be destroyed earlier. Consult a tax professional for retention periods for specific records.

For the growing number of sole proprietors and taxpayers with rental properties, the issue of recordkeeping becomes increasingly important. For small businesses, tracking your income and expenses can be a daunting task. Many sole proprietors will resort to the "shoe-box" method and throw all their receipts and invoices into a shoe box and worry about it at tax time. Although this might seem like an easy solution, it leads to inaccurate returns, missed deductions, and more importantly, if examined it might prohibit the taxpayer from properly substantiating expenses. For those who are self employed (specifically, file a Schedule C) and for those who personally own rental properties (file a Schedule E) sufficient record keeping goes further than the retaining of receipts and statements. Investing in an accounting software package could prove to be very beneficial to you and your business. Luckily, there are many low-cost applications available.

Having accurate, up to date accounting records not only provides you with the financial information needed to effectively run your business, it also eliminates the possibility of human error in adding up all your invoices and sales receipts at year end. Additionally, these programs are usually equipped with a bank reconciliation module which will aid in assuring that you have recorded and deposited all expenses and income items. These applications are easy to use and require little knowledge of accounting and bookkeeping.

The new IRS program can be seen as a reason to sound the alarm or an opportunity to finally get your financial records in order. At the end of the day, the IRS is simply looking to ensure that those who should be paying tax are paying it. Without proper records, a taxpayer runs the risk of paying more than their "fair-share" should they come under examination. McKonly & Asbury's team of tax professionals is ready to consult with clients on their specific record keeping needs. We are confident that our experience in this area will add much value to your personal and business record keeping efforts.

Coming this fall, our tax team will be conducting a seminar on IRS audits and what you can expect if you get that letter or phone call from Uncle Sam.  Stay tuned to future editions for more details!  In the meantime, if you have a question, contact our tax team.